The Golden Era of Defensive Stocks

Shmulik is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

For the past few years, some analysts warned against investing in defense contractors. Their thinking is that the U.S. government will "get religion" and reduce spending… even on the defense industry, which is in enough foreign wars that it should be called the "offense industry." So it’s time to sell defense stocks and jump into sectors offering better growth prospects, right?

Wrong.  Unless you like taking risks, having the equities of big military suppliers in your portfolio is almost always a smart move.  Although politicians love to bash the defense industry, its stocks offer unique characteristics that most investors can’t obtain any other way. And it shows in the performance of defense stocks. 

The market has spoken

The chart below displays the performance of "offense" contractors Northrop Grumman (NYSE: NOC)Lockheed Martin (NYSE: LMT) Elbit Systems (NASDAQ: ESLT) over the past 12 months. These companies produce things like jet fighters, missiles, radar systems, and unmanned aerial drones. They rely almost entirely on government spending. Last year, Northrop got 90% of its business from the U.S. government. For Lockheed, that number was 82%. Together, these two companies alone raked in more than $60 billion in government money last year.

<img alt="" src="http://chart.finance.yahoo.com/z?s=LMT&t=1y&q=l&l=on&z=l&c=ESLT,NOC,%5EGSPC&a=v&p=s&lang=en-US&region=US" />

The red line above shows the performance of Northrop, the blue line shows the performance of Lockheed, and the green line stands for Elbit. For Comparison purposes, I added the S&P 500 in purple to serve as a benchmark. As you can clearly see, over the past year - it's been highly profitable to play defense. All three defense stocks have climbed by 30% to 40% a year, easily besting the S&P. Last week, these three stocks broke out to their highest levels in more than four years. Despite claims to the contrary, no cutbacks are affecting these stocks.

The unique traits of the defense industry

Let’s take a look at three reasons why defense stocks are now booming and are more than likely to continue their uptrend. 

Counter - cyclical

Right now, China and Europe are slowing down and the possibility of another Middle East war looms as Israel prepares to attack Iran’s nuclear complex. If Israel strikes, that will probably lead to Iranian missile launches, action in the Strait of Hormuz, spiking oil prices and other developments that depress the shares of most commercial companies. But not defense shares. When war looms, demand for the goods and services of military suppliers rises. That's why defense stocks are regarded as counter- cyclical.

Always in demand

Within the domestic defense market, industry has evolved in a way that makes it highly resilient to softening demand.  When the Cold War ended, the top tier of the sector consolidated into a handful of military conglomerates that do business with all the military services in both hardware and services.  Waning demand in any particular market segment presents little threat to these sprawling enterprises. The industry is so concentrated that there often are only one or two qualified suppliers of key military items, and politicians usually are determined to keep it that way.

Cutbacks or no cutbacks

The defense sector is usually immune to budget cutbacks. That's because the safety of lives always comes first. Everything else - consumer spending, interest rates and health insurance - all come later. Also, politicians hate the thought of being blamed for being negligent with American lives. The best way to avoid that is not to cut back spending on defense.

Going forward

Shares of all three companies appear ripe for further gains in the near- term future. Northrop has just delivered the first of four AQS-24A airborne mine-hunting vehicles to the Japanese Maritime Forces. This deal represents a major milestone in the development of Japan's military capabilities. A successful transition is likely to lead to further additional orders for Northrop. At a price-to-earnings of only 10 and price-to-sales of only 0.8, the market hasn't priced any upside potential in Northrop's shares.

When it comes to Lockheed, the future also seems rosy. The company just secured a $28 million contract from the Pentagon, maintaining software aboard Air Force C-5 Galaxy transport aircraft. At only 0.7 times book-to-price, Lockheed seems to be suffering from the same discount mispricing at its rival, Northrop.

Elbit, the smaller of the three, hasn't seen its best days. Israel is currently funneling all ot its F-35 aircraft orders through it. With the middle east looking the way it looks today...only more orders from Elbit are likely to follow. 

The Fool plays defense

Very often, we tend to think of defense stocks as boring and uninteresting. The truth of the matter is that defense companies have immense barriers to entry, they are virtual monopolies and they enjoy a ongoing stream of government spending. In this uncertain economic environment, I believe that defense stocks are place to be. 

 


Shmulik Karpf has no position in any stocks mentioned. The Motley Fool owns shares of Lockheed Martin and Northrop Grumman. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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